Market Risk Analysis Volume I: Quantitative Methods in Finance

I.6

Introduction to Portfolio Theory

I.6.1 INTRODUCTION

This chapter examines the decisions made by investors, asset managers, risk managers and senior managers about their daily business. To utilize their resources efficiently they need to balance high return, higher risk activities with those that have low return but lower risk. But how should they choose the ‘best’ mix of activities? How can a fund manager choose his investments in different assets to optimize the performance of his portfolio? How should he measure the performance of his investments? And how can a senior manager allocate capital to different trading desks in an efficient manner? All the material presented in this chapter is motivated by these optimal capital allocation decisions.

There are two main applications of optimal capital allocation in finance:

• Global Asset Management. This is usually regarded as a multi-stage optimization process: first, select the optimal weights to be assigned to different asset classes (such as bonds, equities and cash); then, within each class, allocate funds optimally to various countries; finally, given the allocation to a specific asset class in a certain country, select the individual investments to maximize the investor's utility. Constraints on allocations may be needed, such as no short sales, or to restrict investments within a certain range such as ‘no more than 10% of the fund is invested in US equities’.
• Capital Allocation in an Investment Bank. First, the board selects ...